Question

In: Accounting

Sadie Manufacturing makes fashion products and competes on the basis of quality and​ leading-edge designs. The...

Sadie Manufacturing makes fashion products and competes on the basis of quality and​ leading-edge designs. The company has $1,500,000 invested in assets in its clothing manufacturing division.​ After-tax operating income from sales of clothing this year is $450,000.

The cosmetics division has $6,200,000 invested in assets and an​ after-tax operating income this year of $1,550,000. Income for the clothing division has grown steadily over the past few years. The​ weighted-average cost of capital for Sadie is 10​%. The CEO of Sadie has told the manager of each division that the division that​ "performs best" this year will get a bonus.

1.

Calculate the ROI and residual income for each division of Sadie Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each​measure?

2.

The CEO of Sadie Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate EVA adjusted incomes of clothing and​ cosmetics, and finds that the adjusted​ after-tax operating incomes are $255,300 and $710,400​, respectively.​ Also, the clothing division has $390,000 of current​ liabilities, while the cosmetics division has only $280,000 of current liabilities. Using the preceding​ information, calculate​ EVA, and discuss which division manager will get the bonus.

3.

What nonfinancial measures could Sadie use to evaluate divisional​ performances?

Solutions

Expert Solution

1) Clothing Cosmetics
Operating income after tax 450000 1550000
Net assets 1500000 6200000
ROI:
450000/1500000 = 30.00%
1550000/6200000 = 25.00%
Residual Income:
450000-10%*1500000 = 300000
1550000-6200000*10% = 930000
The choice of measure chosen to evaluate the mangers, will decide the person
who will get the bonus.
If ROI is chosen, the clothing division will get the bonus (as it has highet ROI); if
residual income is chosen the bonus will go to the cosmetics division.
The ROI is a comprehensive performance measure that takes into account not only the revenues
and costs but also the value of invetment that is used to produce the revenues
and expenses. Further, as it gives the measure as a % return it is easy to
understand; the calculation is also simple.
The major disadvantage, of using ROI is that, it will force managers to reject projects that
have an ROI less than the target ROI, eventhough they have positive NPV. This is against
the principle of maximisation of shareholders wealth.
The residual income measure will not reject projects with positive NPVs and hence is
consistent with the wealth maximisation goal. As a result, firms will not lose projects
that have positive NPV's.
The disadvantage of the RI measure is that, being an absolute measure it does
not consider the size of the investment due to which it cannot be used to compare
divisions that have sizeable difference in value of investment.
2) EVA is given by the formula
EVA = NOPAT-Invested capital*WACC
Clothing Cosmetics
Adjusted after tax operating incomes 255300 710400
Assets 1500000 6200000
Less: Current liabilities 390000 280000
Invested capital 1110000 5920000
EVA = Adjusted NOPAT-Invested capital*WACC
255300-1110000*10% = 144300
710400-5920000*10% = 118400
Using EVA, the Clothing division will get bonus as it has higher EVA.
3) Non-financial measures could be:
*market share
*customer satisfaction
*Defect percentge

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